Certifications

March 23, 2011

Beware the Bond Pundits!

Beware the bond pundits. They seem to have an agenda. It does not include profits for the average investor.

I am trying hard not to go into rant mode. Mrs. OldProf sternly instructed that I could not say "ignorant, clueless bozos." In this redacted version you get a milder story. Many widely-esteemed bond market pundits have a viewpoint that we regard as misguided, and costly to equity investors. Here is why.

The Background

Japanese investors -- government and individuals -- are major holders of US debt. The tragedy of the earthquake and tsunami will require cash for rebuilding. Some observers are highlighting this consideration and the implications for US debt. The conclusion of much of the punditry is that this will cause a collapse of the US bond market, followed by a collapse of equity markets.

The erroneous analysis of the bond market is the most blatant example of a major problem for investors. Even if you are intelligent, attentive, and focused, you will be led astray by what you see online.

Some issues require actual skill to analyze, and the Japan situation is a good example. Let us take a closer look.

The Typical Argument

Most of the talking heads on TV and the big-time blog writers cite the possible selling of US treasuries by the Japanese government and citizens as a major threat. I do not want to pick on any specific source -- there are so many candidates. The general argument is that the Japanese will be selling, China is no longer buying, and -- Woe is me! -- what will happen next? Since no one will be left to buy, the US bond market will collapse and equities will follow.

The general appeal of this argument comes from the "everyman" approach favored by most economic bloggers. This approach depends upon oversimplifying economics, transactions, and relationships.

Here are some simple facts:

The leading economic bloggers are not economists. Seeking Alpha (a great source where I am happy to contribute) ranks the top 20 in the economics category by popularity. Only two of these authors have genuine economic credentials (I am not including myself).

A typical pop economics article tells readers what they already "know." It does not educate nor inform. It treats economics as something everyone already knows from practical experience in reading the news or doing the family budget. There is nothing that needs to be learned. This serves to reinforce existing misinformation.

The pop economists treat every economic relationship as a bargain between two unitary actors. "Japan is selling. Who will buy?"

Most of the real economists do not write on the topics of greatest importance to investors.

This is a sad situation. I wish that universities would reward economists who ventured into the field of finance and investments, helping to highlight truth seeking. The upcoming Kauffman Foundation conference for economic bloggers may provide a forum for this topic.

How does this apply to Japan and the current bond market?

The Reality

The right way to analyze this problem would be to analyze the market microstructure to get a handle on demand. Supply is probably easier, since the normal trading is known and so are the Treasury auctions. The main point is that a serious analyst would use microeconomic principles to derive a demand curve. If the Japanese demand is reduced, that would shift the entire curve. Demand and supply curves would intersect at a somewhat different point, suggesting a different clearing price for US Treasuries. To do this properly requires some data and assumptions about the underlying demand and supply curves.

The analysis would include the following facts (some from a 2008 Fed paper on market microstructure):

Overall federal debt is about $14 trillion. The Japanese government holds about $700 billion and might need to liquidate about $100 billion or so. This would not occur all at once.

Daily trading volume was over $500 billion in 2007 and this did not include futures trading.

The Fed QE II program was for $600 billion over eight months. The pundits are still arguing about whether this buying reduced interest rates. Those who want to claim it was ineffective point out that rates moved higher. Many of these same people now say that the Japanese selling will cause a market meltdown.

A Simple Rule for Reading Economic Articles

Does the author understand that economics involves a distribution of demand and supply? That prices are determined at the margin? That small changes in price may imply great changes in quantity (or vice versa)?

To illustrate with the current example, the Japanese government, should it choose to sell bonds, cannot be treated like the owner of a piece of real estate -- all or nothing at a single price. The Japanese government (or citizens) will be willing to sell more bonds at a higher price, and might not sell any at a low price (choosing to raise funds in another way). The decision is a distribution, not a single, all-in transaction. It certainly does not happen at one point in time.

If you are reading an economic pundit who does not understand marginal pricing, just turn the page.

The market for US debt is deep and liquid. Small price changes draw many more bids from those using yield-based asset allocation models, a large part of the market.

I can't believe that so many clueless bozos mistaken analysts are so eagerly embraced by the media and readers. I guess nothing beats a good story.

An Afterthought

Here is a little mind game that you might enjoy. As you watch the NCAA basketball tournament, switch to an NBA game. Ask yourself if you could tell the difference between college and pros without announcers or uniforms. If you are a real fan, you would find it easy. Similarly, you could tell the difference between pro and college football by the plays and the speed of the players.

Now try it on economics articles or TV appearances. See if you can spot the real economists. If you cannot, you are probably making many poor inferences about economics.

Comments

The economic blog reading community is weighed heavily towards the "Tea-Party" crowd. And they gravitate to articles that affirm their beliefs. These beliefs are that the economy HAS to crash. It just MUST. It HAS TO!

Recently, Barry Ritholz made a post referencing the immense popularity of a post from an MIT professor predicting confidently that the Japanese reactors would not suffer any catastrophic failures. The blog post drew HUGE amounts of traffic eventhough, as Barry pointed out, the actual guy who wrote the post had no expertise in nuclear science.

But that didn't matter to the "conservatives" that read these blogs. They wanted an affirmation that nuclear energy is safe and stupid liberals are overreacting. And this post did the trick.

Of course, I am not saying anything that hasn't been said many times by other media commentators. People have and will continue to gravitate heavily to news sources that affirm what they believe rather than what the truth is. The "Golden Age of Journalism" with the Tom Brokaws and the Walter Cronkites for better or worse is dead and it was the exception rather than the rule. Newspapers have always had the clear biases of their editors and owners. We are just reverting back to the normal now.

I tend to lol at any bond analysis that doesn't include mention of pension funds, life insurers, and p&c companies. You mention the size of the market and I mention some of the larger players ... their demand is very inelastic for a variety of reasons ...

Lou - I am not trying to pick on any specific author. My reaction was actually inspired by someone who was on TV. I cite the SA list just to illustrate the public preference for getting their economics from non-economists.

I read a number of the top 20 because they raise interesting points. I try to note the background and experience of each source.

That is what I recommend for every reader. For these reasons I do not want to post a list or to imply that I think people should read one source versus another.

I could have made the same point by citing the most popular "economic" blogs from any other list.

Jeff - Economists disagree about many things. These may be honest disputes related to differing methods or models. Sometimes the disagreement is more political.

There are some topics related to basic tools and methods where there is widespread, nearly universal agreement. In the matter of market microstructure, the basic tenets of how to derive a demand curve, and the implications therefrom, you will not find dissent.

I am suggesting that we should all identify and accept certain principles and conclusions rather than dismiss all economists because they sometimes disagree.